How an ISA Works

In recent years the government rules on ISAs have been streamlined to make everything easier to understand and more attractive to consumers. Gone are the mini and maxi ISAs and these have been replaced by Stocks and Shares ISAs. The old cash ISA is exactly the same and as attractive as ever, and there are also ISA Bonds, which offer a slightly higher interest rate, with none of the risks connected to Stocks and Shares. For an idea of just how many options the prospective ISA investor has have a look at the ISA page on Legal and General's website.

The annual ISA allowance is currently £3,600 (in regards to cash). This means if you had £2,000 in an ISA at the end of the last financial year you may put in an extra £3,600 (or any sum in between) to make a grand total of £5,600. Now to make things a little more complex, the total annual ISA allowance is £7,200 (when the allowance for stocks and shares is included). The annual ISA allowance is the maximum amount you can invest in one year, not the amount you can have invested.

In the last budget the Chancellor declared the ISA allowances would change. For over 50s they change on the 6th October 2009, for everyone else it's the next year. The changes see the overall allowance rise to £10,200, and the cash allowance rise to £5,100.

The reason why there is an allowance on ISAs is because the government cannot afford everyone to put all their savings into ISAs. ISAs are tax-free, which means the interest you earn cannot be taxed. This makes them better than normal savings accounts with no extra cost to the bank. Basic rate tax payers pay a fifth of their savings interest in tax, whilst high rate tax payers pay double that. With an ISA, therefore, the basic rate tax payer earns an extra 25% interest than with a bank account, and a higher rate taxpayer earns 66% more.

There are some other things that should be considered when it comes to ISAs. Firstly, once you withdraw money from an ISA is cannot be returned. If, for example you have put £3,000 into your ISA this year, and you want to take £2,000 out. Regardless of taking that money out you can only put in an extra £600 (to make up the maximum allowance of £3,600). The ISA allowance operates on a use it or lose it basis, and you can only use it once.

Also bear in mind that you can only have one Cash ISA with one provider in any tax year and you can't split it across several providers. That means if you opened it with one provider, it doesn't matter if the bank down the street has a good offer, you can't open another account and get another ISA allowance. However, you can transfer ISAs from one provider to the other should you so wish.

Cash ISAs are a great place to put your money, they offer good interest and they're completely risk free. They can earn significant amounts of interest, particularly if you're happy not to access your money for a prolonged term. If you haven't got an ISA, you really should open one.